Mondays are rough. Imagine you’re the general counsel of a publicly-traded company, walking into the CFO’s office with news of a patent infringement lawsuit from your biggest competitor. The CFO’s first question? “What legal reserves do we need?” As GC, your focus is on defending the company. But for the CFO, the concern is the business’s financial well-being and the impact on financial statements. Have you considered the financial implications of a possible loss?

Overview

Loss contingencies represent the loss or impairment of an asset due to future events that may or may not occur. Legal reserves are a specific subset relating to potential future litigation events. This post provides an introduction to legal reserves, focusing on loss contingencies for legal risks under ASC 450.

One important distinction to make is the difference between setting accruals or reserves for loss contingencies, and the actual reserving, or earmarking, of certain assets for a specific purpose. Throughout this series, my use of the term “reserve” refers to an accounting accrual.

Authority

Guidance on loss contingencies comes from several sources:

1. Sarbanes-Oxley Act (SOX):

   • Section 302 mandates establishment of internal procedures for accurate financial disclosures.
   • Section 906 attaches potential criminal liability to falsified disclosures.
   • Section 404 requires reporting on the adequacy of internal control on financial reporting (ICFR).

2. Accounting Standards Codification (ASC) 450:

   • The primary authoritative source of GAAP for loss contingencies.
   • Applies to any public or private company that follows GAAP.

3. SEC Regulations: SEC regulations S-K 103 interact with ASC 450-20 - particularly the sections 103 (Legal Proceedings), 303 (management discussion and analysis, or MD&A), and 503(c) (Risk Factors).

ASC 450-10-20 defines a contingency as “an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an entity that will ultimately be resolved when one or more future events occur or fail to occur.”

Why Do We Care?

Legal Requirements and Objectives

ASC 450-20 is central to regulations requiring accurate financial statements and adequate reporting systems. SOX aims to protect investors from inaccurate or misleading financial statements, requiring detailed and accurate books and records that fairly reflect a company’s financial condition.

The SEC has significantly increased enforcement actions related to financial reporting and disclosure. During the 2015 and 2016 fiscal years, the SEC brought more than 200 financial reporting and disclosure actions, which was more than double the number of cases brought during the prior two years. This trend has continued, with the number of standalone enforcement actions per year ranging from 405-526 during the past six years. (Fun fact, and a nod to a future post: 2024 was the first year that the SEC filed an enforcement action related to “AI washing”.)

The SEC’s Financial Reporting and Audit Group uses data analytics and technology-based tools to strengthen enforcement efforts. Given these trends and the increased focus on financial reporting and disclosures, corporate officers are facing more risk than ever.

Business Decisions and Board Oversight

Understanding legal reserves is crucial not only for financial reporting but also for strategic decision-making and effective board oversight. Here are key considerations:

Accurate Liability Estimates

ASC 450-20 provides guidance on how to accurately account for contingent liabilities under an accrual method of accounting. It’s designed to provide both shareholders and management with reliable information necessary for informed decision-making.

While GAAP generally favors conservative approaches, overestimating liabilities can be as problematic as underestimating. Overestimated liabilities can result in understated net income and earnings per share, potentially leading to stock price decreases, affecting investor sentiment, cost of capital, and employee satisfaction.

Timely Liability Estimates

Estimated contingent liabilities should be updated when any of the following occur:

1. The company becomes aware of the liability or potential liability;
2. The liability is resolved, settled, or no longer exists; or
3. As part of the preparation of financial statements.

An update may also be necessary if new information would have a material impact on the financial statements: these updates often co-occur with a company’s filing of a Form 8-K.

It’s important to note that legal costs should not be accrued as part of contingent liabilities.

IFRS Perspective on Legal Reserves

While our discussion so far has focused on US GAAP, it’s crucial to consider the international perspective, particularly the International Financial Reporting Standards (IFRS); many countries around the world use IFRS, and understanding the differences and similarities with US GAAP is essential for global businesses.

IAS 37: Provisions, Contingent Liabilities and Contingent Assets

Under IFRS, the equivalent standard to ASC 450 is IAS 37. While there are many similarities, there are some key differences to note:

Companies operating in multiple jurisdictions or considering international expansion should keep in mind that the differing thresholds for recognition and measurement can lead to variations in reported liabilities between IFRS and US GAAP financial statements. They should be prepared to explain any material differences in their treatment of legal reserves under the different accounting standards to investors and analysts.

What’s Next?

Future posts in this series will explore:

• When to accrue and when to disclose legal reserves
• Why the reserve setting process matters to various stakeholders
• Known and unknown risks and their impacts on legal reserves

Understanding and managing legal reserves is crucial for accurate financial reporting, risk management, and strategic decision-making in today’s complex business environment. By mastering these concepts, companies can better navigate legal uncertainties while maintaining financial integrity, and boards can provide more effective oversight.